Annuity Tax Treatment: What You Need to Know

How Are Annuities Taxed?

Annuity taxation depends on whether the annuity is qualified (funded with pre-tax money) or non-qualified (funded with after-tax money).

Qualified Annuities (401k/IRA Rollovers)

If you fund an annuity with a 401(k) rollover or traditional IRA funds:

• Money went in pre-tax — you’ve never paid taxes on it
• Growth is tax-deferred
• All withdrawals are taxed as ordinary income
• RMDs apply starting at age 73
• 10% early withdrawal penalty if under 59½

Non-Qualified Annuities (After-Tax Money)

If you fund with personal savings (not from a retirement account):

• Your principal (cost basis) already been taxed
• Growth is tax-deferred
• Only the growth portion is taxed upon withdrawal (LIFO method)
• No RMDs required (unless inside an IRA)
• Exclusion ratio for SPIAs — only the gain portion of each payment is taxable

The Exclusion Ratio for Immediate Annuities

For non-qualified SPIAs, the IRS calculates an “exclusion ratio” — the portion of each payment considered a tax-free return of principal. For example, if you paid $100,000 and will receive a total of $200,000 in payments, 50% of each payment is tax-free until your basis is recovered.

1035 Exchange: Tax-Free Swap

Under IRS Section 1035, you can exchange one annuity for another without paying taxes on accumulated gains — as long as the exchange is done properly (directly between carriers). This allows you to upgrade to a better product without a tax hit.

Estate and Inheritance Tax

Annuity death benefits paid to beneficiaries are subject to income tax on the gain. They do not receive a step-up in basis like stocks and real estate do. Plan accordingly.